Basis Planning: Qualified Small Business Stock Exclusion

Considerable time these days is spent identifying ways to include the value of trust assets in the settlor’s gross estate in order to obtain an income tax basis adjustment to those assets. But the settlor or beneficiary’s death is a condition to this planning strategy. What if capital gain exclusion could be obtained while the settlor or beneficiary is still alive? IRC 1202 provides a possible answer.

The 2017 Tax Cut Act lowered the corporate income tax rate for C corporations from 35% to 21%, while it permanently repealed the alternative minimum tax for C corporations. Consequently, use of a C corporation is more attractive as a business vehicle than it used to be, especially for a start-up business entity that does not anticipate making substantial distributions to shareholders for several years.

Sometimes overlooked is the additional income tax advantage of the qualified small business stock exclusion (QSBS) under IRC 1202 for C corporations. This Code Section was enacted in 1993 which became permanent in 2015. The capital gains tax savings that qualify under IRC 1202 can be significant. As a generalization, some or all of the capital gains that result from the sale of QSBS stock can be realized tax-free.

Key conditions to the QSBS exclusion are that the (i) non-corporate shareholder, i.e. an individual (ii) acquires the QSBS at original issuance (iii) who holds the QSBS for at least 5 years. If the QSBS was acquired any time after 9/28/2010 the individual may be eligible to exclude up to 100% of the capital gain on the disposition of the QSBS, including an exclusion from the 3.8% Medicare surtax, i.e. the net investment income tax.

This long term capital gain avoidance opportunity exists for stock in a ‘qualified trade or business.’ The IRS has held that IRC 1202 is not available for a business that is ‘primarily engaged’ in providing services. [Private Letter Ruling 201436001.] Only recently however has the IRS provide a bit more insight on what constitutes a ‘qualified trade or business’ for corporate stock to qualify under IRC 1202. In June, 2021, the IRS concluded the manufacturer of products prescribed by third-party health care providers was engaged in a ‘qualified trade or business.’ [Private Letter Ruling 202125004, June 25, 2021.] The IRS determined that although the business’ products were associated with the health care industry, it did not perform health care services. Even though the business employed specialists, the business’ principal asset did not involve the reputation or skill of its employees. Rather, the specialists were hired to evaluate, design, fabricate, manufacture, adjust, fit and service products for the referred customers. In short, the business derived its revenues from selling products to customers (that were then reimbursed from insurers and hospital systems.) Accordingly, a business that is closely associated with customers whose field is typically service-related may still be able to meet the ‘qualified trade or business’ condition for purposes of IRC 1202. That said, rather than rely upon private letter rulings which are not binding precedent for taxpayers other than the party who requested the private letter ruling, Treasury Regulations on what constitutes a ‘qualified trade or business’ for purposes of IRC 1202 are long overdue and would be welcome for those individuals who are contemplating the sale of the qualified small business stock.

Some of the refinements to these basic qualifying conditions include the following:

• The QSBS must have been acquired by the individual at the stock’s original issue, either in exchange for money or other property (not including stock) or as compensation for services provided to that C corporation;
• The C corporation must be a domestic corporation for substantially all of the shareholder’s 5 year holding period;
• A qualified small business’ aggregate gross assets cannot exceed $50 million at or before the issuance of the QSBS (using income tax basis not fair market value;)
• During substantially all of the 5 year holding period at least 80% of the value of the corporation’s assets must be used in the active conduct of a trade or business (not marketable securities or cash, i.e. some ‘working capital’ is permitted.) This test is failed if 10% or more of the corporation’s assets are in stock or securities of other corporations that are not subsidiaries; and
• Renting real estate is not treated as an active conduct of a business, nor are most service oriented businesses. In fact, much like IRC 199A some active businesses are expressly excluded from IRC 1202, such as health, law, accounting, performing arts, farming, banking, and hotels and restaurants.

As noted, the capital gains tax savings upon the sale of QSBS can be substantial. The maximum gain from the sale of QSBS that may be excluded in a tax year is the greater of: (i) $10 million ($5.0 million for a married taxpayer filing separately) less the sum of any gains previous taken by the taxpayer for that specific QSBS issuer in the previous tax years [IRC 1202 (b)(1)]; or (ii) Ten times the shareholder’s adjusted cost basis in the QSBS disposed of during the tax year [IRC 1202 (a)(1)]. If the QSBS was acquired after 9/28/10, these gains will also be excluded from the alternative minimum tax (AMT.) [IRC 1201(a)(4) and 57(a)(7).] Gains recognized above these dollar limits will be taxed at a flat capital gains tax rate of 20%, plus the 3.8% Medicare surtax. [IRC 1(h)(4)(A)(ii) and i(h)(7).]

Consequently, in a period where we now concern ourselves with avoiding capital gains through free-basing techniques like intentionally triggering the ‘Delaware Tax Trap’, or decanting irrevocable trusts to deliberately give the trust beneficiary a general testamentary power of appointment over trust assets to obtain a tax basis adjustment under IRC 1014, all of which deal with post-mortem transfers, IRC 1202 provides dramatic lifetime relief from capital gains taxation to the individual shareholder who holds the QSBS.

Planning opportunities using QSBS to consider include:

• Lifetime Gifts: If any QSBS is received as a transfer by gift (or at death) the transferee is treated as having acquired the QSBS in the same manner as the transferor and having held the QSBS during any continuous period immediately preceding the transfer during which it which it was held (or treated as held under these rules) by the transferor. [IRC 1202(h)(1) and IRC 1202(h)(2)(A).] As a result, the tax benefits that arise from QSBS are not lost if the stock is the subject of a lifetime gift, which may make it an attractive asset to gift if the individual donor wishes to reduce the size of his/her taxable estate while taking advantage of the currently higher federal gift tax lifetime exclusion amount.
• Grantor Trusts: The QSBS could be transferred to a grantor trust. If that transfer is a donative transfer the grantor trust should be treated as having acquired the QSBS in the same manner as the transferor, such that the trust should be able to tack onto the transferor’s prior holding period, although the Regulations under IRC 1202 do not expressly address the transfer of QSBS to a grantor trust. Less clear is the sale of the QSBS to a grantor trust in an installment sale transaction, e.g. a sale to a IDGT. If the sale is ignored, the transfer to a grantor trust should be treated as the equivalent to a donative transfer to the grantor trust. But then the question is what happens to the nature of the QSBS when the trust ceases to be classified as a grantor trust?
• Non-Grantor Trusts: Assume that a wealthy individual owns highly successful QSBS, e.g. he was an original investor in a start-up company that has exploded in value. The wealthy investor creates multiple non-grantor trusts for each of his children. The investor then transfers, by lifetime gift, QSBS to each of those non-grantor trusts. Each of those non-grantor trusts can claim its own $10 million QSBS gain exclusion, separate from any QSBS that the investor decided to retain. The Regulations do not expressly address this possibility, but IRC 1202(h)(2) is pretty clear that the donee/transferee of the QSBS that is obtained by gift or bequest is treated as having acquired the QSBS in the same manner as the donor/transferor, and that the donees of the QSBS can tack the donor’s holding period onto their own holding period. Thus, it may be possible to stack several IRC 1202 QSBS exclusions through the use of multiple non-grantor trusts well beyond the dollar limits earlier described.
• Conversions: If any QSBS is acquired solely though the conversion of other stock in the corporation which is a QSBS in the hands of the individual, then the stock so acquired is treated as QSBS in the hands of that individual and is treated as having been held during the period in which the converted stock was held. [IRC 1202(h).] An S corporation cannot be converted to a C corporation in order to then qualify for the IRC 1202 gain exclusion. But an LLC can be converted to a C corporation to thereafter qualify for the QSBS exclusion. [ See, PLR 201636003, where the LLC had elected to be taxed as a corporation and was permitted to claim the IRC 1202 exclusion after the conversion.]
• ‘Rolling’ QSBS: If the individual holds QSBS but has not held it for the full 5 year holding period in order to qualify for the gain exclusion on sale, the individual (other than a C corporation) may sell his/her QBSB without recognizing any gain under IRC 1045, if the individual has held the QSBS for more than six months. The rollover must occur within 60 days of the sale. Cash ‘taken off the table’ would, however, be subject to the capital gain tax.
• Planning Trap: QSBS that is transferred to a family limited partnership (FLP) or family limited liability company (FLLP) as part of a sophisticated family wealth and transfer tax planning strategy will not retain its character as QSBS as the FLP/FLLC did not receive the shares on the original issuance from the qualified small business.

If the goal is to exploit the qualifying small business stock opportunity in future years, then the need exists to plan for the exclusion now. Key information that will be needed to substantiate the claimed exclusion include:

• Document the date the QSBS was purchased or acquired, in order to identify when the five-year minimum holding period runs;
• Document the amount that was paid, if anything, for the QSBS stock;
• Retain a copy of the share certificate that represents the issued QSBS stock; and
• Obtain a certification from the issuing corporation that: (i) it is a domestic C corporation; (ii) it has less than $50 million in assets after the purchase of the original shares of QSBS stock; and (iii) that at least 80% of its assets are used in an active and qualifying trade or business as identified in IRC 1202.

In sum, as new operating businesses are formed, and the choice of entity becomes of the question of the day thanks to IRC 199A and the new corporate income tax rate of 21%, some thought needs to be given to forming a C corporation, not only due to the lower ‘new’ lower federal income tax rate, but because of the incredible gain exclusion opportunity that comes with the C corporate stock classified as a qualifying small business stock, not only for the initial investor, but also that investor’s family members far into the future who may be gifted that QSBS stock.

Source: Jenson & Kohn, Estate Planning, Vol. 45, No. 10, October, 2018

Updated: March 2022